Sunday, August 20, 2017

Power from Arbitrary Places: What Awards Can Do

We have a general idea that status and prestige can do things – good things – to a person or organization. We are all familiar with how the prestigious classes of wine demand higher prices, even for a given quality level; there is evidence on this in research on French and California wines. Status effects are also well known from many other contexts, and a more-consequential example is financial markets, in which the most prestigious banks gain price and distribution advantages over all others.


A new paper by Anne Bowers and Matteo Prato in Administrative Science Quarterly gives interesting new details on the effects of status. They look at equity analysts, who seek to help investors in the stock market by issuing reports on firms and estimating their future earnings. This is difficult work, both in getting the estimates right and in gaining the confidence of investors, but some analysts are so highly regarded that their estimates can move the price of stock they report on. They have market power even though they just act as observers and forecasters. But how can an investor determine what analyst to pay attention to?

Conveniently, there is the magazine Institutional Investor, which caters to the large (and very powerful) institutional investors such as mutual funds and pension funds, as well as ordinary investors. The magazine has an annual All-Star award, given mostly for accurate estimates but also for other qualities such as high service to customers (again, institutional investors). This award is prestigious, but it is also a sign of quality. If the market could consider the quality and prestige aspects of the award separately, someone who was nearly good enough for the award should gain nearly as much power as someone actually getting it. You are probably guessing that this is not what happens. And you are right.

Bowers and Prato had a very clever way of finding this out. The award is given across many categories of equities, and these categories often change through addition, deletion, combination, and splitting.  This is neat because it means that an analyst could become an All-Star, or lose an All-Star award designation from a prior year, simply because the categories changed. Focusing only on these changes in awards, they found that the difference between having an award and not having one was a great deal of market power. Gaining an award meant that an analyst moved stock prices much more; losing one meant that an analyst moved prices much less.

The second of these effects should give you pause. Financial markets are supposed to be smart and to be able to predict the average outcome of many future events. But the loss of market power when an analyst loses the All-Star distinction because of a category change suggests that the markets are forgetting what they knew. The quality of an analyst doesn’t suddenly change, so if the market power changes, we know that the market has forgotten the quality. This is not good news for those of us who let institutional investors such as mutual funds or pension funds hold our pension investments.

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